My Blog

September 25, 2008

What was supposed to be largely a US financial crisis seems to be spreading even further.  This might come as both a surprise and an annoyance to those who believe that the cause of the crisis was specific mistakes made by US bankers and regulators, but much less of a surprise to those who assume that runaway monetary expansion always leads to very risky and vulnerable financial systems, and the list of countries that have tolerated or even exacerbated runaway monetary expansion is a very long list.

Here in China, in sympathy with the weirdness abroad, the stock market is still racing around erratically.  On Wednesday the market bounced up and down violently several times before ending the day with the SSE composite up 15 points, or 0.7%.  Today, prices surged 5.3% within two hours of opening, and then gave some of it back to close at 2297, up 3.6%. 

The market surged, according to Bloomberg, “after the country’s two exchanges eased restrictions on equity buying by controlling shareholders and on speculation government-run investors increased purchases,” although I think the bank share purchases have been, fortunately, quite small (an article in today’s Xinhua stated that the net purchases of shares by Central Huijin in the three big banks amounted to increases in ownership of well under 0.001%).  The Bloomberg article goes on to say:

Under new rules taking effect today, the period in which controlling shareholders are barred from raising their stakes in publicly traded companies has been cut to 10 days before earnings are released, from 30, according to statements from the exchanges.  China's state-owned companies should be “a role model” in promoting “stable” development of the nation's capital markets by buying back shares in publicly traded units, the State-owned Assets Supervision and Administration Commission said Sept. 18.

Aside from the fact that to be a “role model” these days is pretty narrowly defined (you must simply buy shares), my former students in the market tell me that there is also serious speculation that securities rules will be changed to allow shorting and margin investing.  Although I am not sure either of these measures is likely to add stability in what is a highly speculative market (on the contrary), to some extent these rumors are more of the same old stuff.  Basically what is driving the market is government intervention and government signaling. 

Given how chaotic and dangerous markets have been recently, this is probably as good a time as any for market intervention, and certainly Chinese policy-makers are not the only ones around the world who think so, but investors here have been so conditioned to think of the market’s performance as almost exclusively a function of government behavior that I am afraid that the impact of the latest round of activity in China will be far more ephemeral than it might be in other markets.  Once investors perceive that the government has run out of ammunition or new tricks to spur the market, prices will plunge.  Once the market stops surging, it will very quickly lose its legs as investors pile out waiting for the next bag of tricks, and we’ll soon be testing the lows again.

More interesting to me than the stock market were events in Hong Kong concerning the Bank of East Asia.  After several days of rumors and speculation, long lines of depositors are now lining up at the bank desperate to take their money out – and have been so since late last night.  Deposit withdrawals actually began on Tuesday, but only really picked up steam last night.  Bloomberg says this is Hong Kong’s first bank run since the Asian Crisis of 1997, but the South China Morning Post lists the last bank run as BCCI in 1991.

The chairman of the bank, David Li Kwok-po, is apparently furious at what he calls “groundless” rumors about solvency problems at his bank and he and Hong Kong regulators are loudly proclaiming that the bank is perfectly safe, but, whether they are telling the truth or not, this is the way bank runs work.  There is no strong incentive for depositors to trust the safety of the bank, beyond their giving up a few days of (low) interest, and every incentive for them to flee to safety.  Even if every one knows that the bank is safe, simple game theory suggests that once the process starts, until something happens to signal that the game is over it makes sense to withdraw deposits.  More ominously, two other local banks, DBS and Dah Sing, are also now subject to rumors.  By the way there is an interesting article on the subject in today’s South China Morning Post, which also has a brief history of Hong Kong bank runs.

Interestingly enough, according to today’s South China Morning Post, one of the factors in the bank run was the wide diffusion of mobile phone SMS and BBS postings warning that there was trouble in the bank.  There was also a seemingly unrelated news story in the same newspaper about the closing down for three months of China Business Post, “one of the oldest financial newspapers on the mainland,” for a “scathing” report in July on Agricultural Bank of China.  Apparently the newspaper received an unexpectedly harsh punishment for reporting a story about fraud at ABC, which was later denied by the bank.  Why such a harsh punishment?  Could it be that authorities are worried by negative articles about mainland bank practices?

Regular readers of my blog know that I am always interested in the phenomena of bank runs.  They almost always come as a shock to places and institutions where only a short while earlier most people would have considered them inconceivable.  But the more overextended a bank’s balance sheet is, the smaller the shock needed to cause a sudden contraction, and as Nassim Nicholas Taleb has pointed out several times – often a little grumpily – these are not events whose probability can be statistically modeled in a meaningful way.  Under current conditions, we can only say that unexpected events like bank runs should not be considered unlikely.  This obviously has implications for the Chinese banking system – which actually experienced bank runs not so long ago, earlier in this decade. 

And implications also for the country’s currency regime.  A lot of people have been asking me recently about China’s strategy for the RMB.  Should China continue forcing the RMB up, or is it time to change strategy?  Given the possibility of slower export sales, might we even see depreciation?

I have never believed that the purpose or RMB appreciation was directly to rebalance trade.  For several years China needed to revalue the yuan not to reduce the trade surplus but rather to regain control of its monetary policy.  If it was able to regain control, the trade surplus would automatically decline anyway because what was pumping exports was the surge in industrial production caused by the channeling of China’s money growth into the banking system – fueled at first, in a self-reinforcing feedback loop, largely by the impact of the trade surplus on reserve accumulation.

At first the main source of money inflow was the trade surplus.  While this continues to be large, in the last year it has been speculative inflows that have driven reserves up.  China’s currency regime needs sharply to reduce the latter and to bring the former to a more reasonable level. Until the now it seemed to me that the only way to do so was to engineer a maxi-revaluation.  But there are four things that can, in principle, reduce the need to revalue, although all of them, one way or another, create problems for the economy. 

1.       If global growth slows sharply, China’s trade surplus is likely to decline.  This will reduce the impact of the trade surplus on reserve accumulation and so slow money growth.  A reduction in the trade surplus might not be enough by itself to allow the PBoC to regain control of monetary policy, but if slowing export growth leads to slowing economic growth, which then also reduces capital inflows, it might be more than enough.

2.       If the prospects for asset appreciation (including currency appreciation) decline, speculative inflows will slow or even reverse, thus removing the biggest recent source of unstable growth in reserve accumulation.  This means that when investors expect lower returns from their Chinese investment, the incentive to bring money into the country to invest will, of course, decline.

3.       If the currency is forced to appreciate surreptitiously via a surge in inflation, China can eventually reduce net inflows once the currency is perceived to be overvalued and expectations of a Vietnam-style depreciation set in – but of course in that case China will have anyway achieved everything it was hoping to avoid.

4.       Most dangerously, if the perception of risk in the financial system (or anywhere else in the economy, for that matter) rises, investors will begin to exit, and the worse the perception of risk that faster the exit.  At some point it even becomes self-reinforcing, as fleeing investors force an uneven contraction of the money supply, this exacerbating risk.  Unfortunately it is exactly the uncontrolled growth of money in previous years that would create the conditions for a surge in the perception of risk, by causing serious overextension in the country’s formal and informal financial systems.  This was always, in my opinion, the strongest reason for a maxi-revaluation: get monetary policy under control before the banking system became too risky

5.       Of course the fifth option, which is the one I had always supported, is that China revalue the RMB substantially (and in one maxi-revaluation) to reduce or even reverse capital inflows and, by reducing the consequent monetary growth, eventually slow industrial production.  This was never going to be a painless option, but I expected that if China waited too long it was likely to see either #3, a surge in inflation, or #4, a breakdown in the financial system.  It may be too late to take that option – certainly under current conditions it would be very difficult.

It seems to me that we may be seeing all of these things happen at once.  It is too early to say, of course, but it is pretty easy to construct a plausible scenario where the US and Europe reduce their imports substantially (so reducing or even reversing China’s export growth), investors both expect lower returns in China (the pressure for currency appreciation declines) and see higher risk in the banking system.  Whether this is accompanied by inflation or not will depend on the actions of the PBoC and on how robust and stable the financial system is, but either outcome is pretty negative.

The outlook is worrying.  I guess I generally try to achieve a balance between expressing my deepest worries about the banking system and being excessively alarmist in public, and this has been a particularly difficult balancing act in recent weeks, but every week it seems the banking crisis steps into yet another market.  Where will it go next?

Comments (10) for "Bank run in Hong Kong"

Dear Prof. Pettis, I am regular reader of your fantastic blog. Its really the best view on China and the world as well. Your option of one-time maxi-revaluation seems most potent. It may also bring the Chinese consumer in the fray and thereby kickstart the global demand growth we are sorely missing. The pain is this will imply some sort of shakeup in China's manufacturing community as well as global manufacturing companies. I think without Chinese consumer - global demand engine will remain weak and we will continue to languish. I think we are at the point where centrality of 1.6billion people to the future of world is realised. Hopefully peacefully and seamlessly. By Rahul Deodhar - 9/24/2008 8:26 PM

HK bank run has ended for now. Nothing to see here. Move on. I totally agree on the 5 options of the RMB exchange rate change. Option 1 is widely expected and happening right now. Some policies have been implemented to address that. Option 2 is welcome, at least for now. As for option 3, inflation is more or less under control for now. I am not sure how big an impact it has. Option 4 is certainly dangerous. But since the government is still credible on its ability and will of backing the bank system (I have not been in China for a few years, is there any change in opinion on this one?), it won't be a serious issue now. If the recession extends well into 2nd half of 2009, and China does not adjust well, that will be a problem. Option 5 is defintely out of window, again, for the foreseeable future. By fatbrick - 9/24/2008 9:18 PM

why I can not found the july data about the dollar reserves on the PBOC webpage? It seem like they stop the data publication since jun. By bomlat - 9/25/2008 3:09 AM

"The outlook is worrying. I guess I generally try to achieve a balance between expressing my deepest worries about the banking system and being excessively alarmist in public..." Achieve a balance? You're kidding, right? Isn't one's deepest worry a form of "alarmism" (hey, a new catch word!)? You are 90% alarmist, 10% guarded. You tell it like it is. Spreading fear like jam on toast. Sells better than optimism, haven't you found? By Ken Novak - 9/25/2008 11:07 AM

Michael, it is time to let go the Rmb appreciation idea for the time being, outlook on China growth, asset market, capital flow, basis balance and FX is decidedly gloomy, this is the first Global Capitalist Downturn for China and better prepare for it. To survive and stabilize macro pictures, more likely government will orchesrate: 1. Massive fiscal expansion in the range of 2-3 ppt GDP: tax cut,social spending and infrastructure investment and Defense, R&D. 2. Move to more aggressive monetary easing, 200bp rate cut in both deposit and lending, abolish quantitative credit control. Damn the inflation, if depositors are so risk averse and willing to live with -2ppt real rate, stop buying property, investing and consuming durables, therefore increase deposit by Rmb3 trillion in 2008 and torpedoed the asset bubble, central bank should recognize the implications of this explosive risk aversion and implied massive tightening of monetary conditoins by easing dramatically. Guess when FED eased again, PBOC will jump on the bandwagon. 3. In times of crisis, better take exchange rate volatility out of macro equation, appreciation urther is neither fundamentally justidied by growth, balance of payment, asset market, nor politically desirable. However, depreciation risk shaking market expectation and causing panic and further tank asset prices. The lesson of 1997-1998 is fixed exchange rate, more or less PBOC already repegging Rmb to USD at 6.8 level and market recognize it by moving the whole NDF curve till 10 year around it. ( however, the 10% + implied vol in Rmb indicated very assymetric distrust whether some big devaluation might result from crash landing of economy) 3. A massive banking crisis is unlikely in China, the overall level of leverage in corporate, household and Banks are manageable. IT is the US and anglo financial system and debt-consumption economic model are in bankruptcy, while Asian saving-investment model in ok shape, at least for time being. So as long as Chinese government continue to print money, spend and build stuffs, chinese consumer-investor convinced out of their asset bust pessimism through robust -credible policies in asset market, China can muddle through , lets face it 6-7% GDP growth is achievable and nothing to be ashamed of. By isaac - 9/25/2008 11:09 AM

First it was US dogs and cats. Then it was Chinese babies. NOW it is gorillas!!!??? According to their doctor, Dr.Zhangxu, this is actually true. Also, there are now reports that intentional milk adulteration has been practiced for years at the large collection points, and not only with melamine but with other additives/chemicals to improperly boost results of the stringent milk protein test. One can only hope that if Hangzhou Wildlife World is going to poison their gorillas, in the future they will leave the rest of the gorilla population well enough alone back in Africa. And, in the future, promise to only feed Wildlife World gorillas food which is imported to China, and no local fare. After all, as we can now see, this was the correct (not controversial) choice of many countries competing in the hallowed olympics. Smart countries chose to import food for their athletes in the olympic village. Not gamble on the Chinese being able to provide quality food. Still, lovers of Chinese cuisine, who are addicted, must just keep enjoying it, and hope for the best. Now lets have some of that MaLa麻辣 HuoGuo, and don't spare the chilli! Man, that's good! By Malahuoguo - 9/25/2008 11:34 AM

Fatbrick and Issac, I agree that the option of a maxi-revaluation is probably dead, and should be. The risk was always that if we waited too long to regain control of monetary policy, the financial system would be too weak to withstand the shock of a revaluation, and I think that may have happened. At this point in my opinion there are very few steps that the authorities can take besides praying that the global slowdown isn't too rapid or doesn't affect China too much, that NPLs stabilize, and that credibility is maintained. Issac's proposals make sense up to a point but I do not think they are likely to make a big difference because the combination of the currency regime and system leakage will diminish loosening policies as effectively as they diminished tightening policies. Where I disagree with Isaac is on the health of the banking system and of corporate balance sheets. I think things look ok (barely) if we look only at the commercial bank balance sheets, but as I have argued many times here, I think all the real lending growth has occurred outside the commercial banks. On that issue, Fatbrick, I think the government certainly has credibility but that it is of a very brittle sort. People do trust the government up to a point, but that trust can collapse very quickly. I saw the process first hand in 2003 during the SARS crisis, and also saw it after the chemical explosion near Harbin (two years ago, I think). The discussion about schools during the Sichuan earthquake suggested how worried the government was about such a collapse of confidence because it was very quickly taken off the list of things that could be discussed publicly. As I see it that means that as tensions in the banking system rise, the impact at first will be negligible because everyone will think the government can and will control it. At some point, however, credibility can evaporate almost overnight. This suggests to me that China can withstand small problems better than most but suffers big problems worse than most. Obviously this is only an impression and cannot be proved or disproved until after the event. By the way, Isaac, 6-7% growth might be nothing to be ashamed of in most contexts, but if at least 10% growth is needed to keep unemployment from growing, as many economists smarter than me believe, 6-7% growth can have serious political implications. Boomlat, the PBoC publishes reserve data on a quarterly basis. Monthly data came though very credible leaks. These leaks have stopped since June. We are all trying to figure out why. By Michael Pettis - 9/25/2008 6:05 PM

These days, Ken Novak, "alarmism" IS realism. By Chicken Little - 9/25/2008 9:34 PM

Michael, agree with your assessment, when economy slipped fast into recession in China ( 6-7%), we have to be careful about normal assumptions about financial stability, social-political coherence By isaac - 9/26/2008 10:38 AM

FATS- Forex Automatic Trading Systems- Research and development of the holy grail, fully. By forexbacktestingsoftware.com - 10/7/2008 10:34 PM